Oil ETFs…With A Twist

While most portfolios are dominated by exposure to traditional asset classes such as domestic and international stocks and bonds, the past few years have seen investors gradually expand the universe of investable assets to include commodities and other types of “alternatives.” In part as a result of the surge in the number and availability of exchange-traded products, investors have embraced ETPs as tools for tapping into corners of the market that were previously beyond their reach.

One asset that consistently generates interest as an investment destination is oil, which has seem both tremendous rallies and steep declines over the last several years. Due to the direct impact of higher oil prices on the lives of many Americans–rising crude oil prices means higher expenses at the pump–there is some intuitive appeal to maintaining a small allocation to oil in a long-term portfolio [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].

There are a number of different ways to gain exposure to energy prices through exchange-traded products, including through direct investments in futures contracts and indirect exposure through stocks of companies engaged in the extraction and production of oil and gas. Among the most popular choices are the United States Oil Fund (USO) and Energy Sector SPDR (XLE).

But that is hardly the extent of ETF options for exposure to the energy sector; there are a number of other lesser-known options that deliver unique ways to bet on energy prices [see also 25 Ways To Invest In Crude Oil]:

Many investors would agree that one of the major drawbacks of achieving commodity futures exposure in a portfolio is the impact contago can have on bottom line returns. While most try to avoid this issue, UBS has successfully been able to design a product that essentially exploits contago in one of the most heavily-traded energy futures markets. OILZ is linked to an index that effectively maintains short exposure in front month oil futures contracts and long exposure in mid-term oil futures contracts, resulting in a net long position in oil [see also Understanding Contango Through Natural Gas Futures].

More specifically, the fund establishes a 100% long position in sixth, seventh, and eighth month Light Sweet Crude Oil Contracts (WTI), and a 50% short position in front month WTI contracts. This methodology allows investors to capitalize on structural inefficiencies in the oil futures market by essentially shorting out the contracts that are most often adversely impacted by contago. The unique combination of long and short exposure means that OILZ will generally exhibit significantly lower volatility than the more traditional, long-only, oil futures funds.

This fund is part of the unique suite of Trendpiliot ETNs from RBS, and may appeal to investors looking for a low-cost and low-maintenance way to apply one of the most popular trend following strategies to the oil futures market. TWTI tracks a dynamic benchmark that is designed to oscillate between crude oil futures and cash depending on recent market trends. The strategy implemented by this product is relatively straightforward: when the RBS 12-Month Oil Total Return Index is above its 100-business day simple moving average for five consecutive days, the fund will track the performance of that benchmark. If the index is exhibiting a negative trend (i.e. closing below its moving average for five consecutive days), TWTI shifts its exposure to cash [see also Examining “Dynamic” ETFs].

The strategy essentially allows investors to establish a long position when oil is rallying, while at the same time minimizing downside losses when oil prices decline. It is important to note however, that the slope of the oil futures curve will effect both the timing of the switches between the two types of exposure and the returns generated after TWTI shifts to oil futures contracts.

For investors wishing to avoid the nuances of futures-based products, FRAK is perhaps one of the most intriguing and innovative equity ETFs offering access to the “unconventional” niche of the oil & gas market. Instead of focusing on Big Oil – companies such as Exxon Mobil and Shell – FRAK’s underlying holdings consist of companies that generate at least 50% of their revenues from less conventional energy explorations techniques.

Specifically, FRAK invests in companies that are engaged in the exploration, development, extraction, production, and/or refining of shale gas, coalbed methane / coal seam gas, and oil sands. In many cases, these companies exhibit a high growth potential since they are utilizing techniques that allow them to discover oil and gas supplies that had previously been impossible to extract. It is worth noting, however, that there are some risks associated with this segment of the oil & gas market: some of the techniques are currently being investigated by regulators and environmentalists to determine the impact of negative externalities created by these operations [see also 25 Ways To Invest In Natural Gas].